Can I Have Your Space Back? – Revisited: Pay me

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Last week’s posting about a landlord’s negotiated right to “recapture” space generated comments reflecting somewhat divergent views, both here and on some social networking sites. That’s good. That was the idea. So, with last week’s posting freshly in mind, we’ll plunge in.

Other than for the rent coming in, empty space, especially at a retail project is an anathema to a landlord. If nothing else, it says: “failure.” Of course, there is nothing to stop either the landlord or the tenant from going to the other and working out a deal: “I’d like your space back; would you like our space back?” A discussion-enabling lease clause is not a prerequisite to either party picking up the phone. We think a lot of us have forgotten this approach.

So, what we have been talking about is really the unilateral right to end a lease ahead of its expiration date. Like a lot of lease provisions, there isn’t“mutuality” in the way recapture provisions work. A basic premise when it comes to a lease is that each party is bound for the lease term. The tenant has to pay rent even though it may no longer have use for the leased space; and the landlord has given its tenant exclusive possession of the leased space for the entire lease term even if a better deal comes along. The market has perverted this notion somewhat. It has “validated” the concept of ending a lease term “early,” but this right seems only to be for landlords. Yes, landlords don’t want to rely on their tenant’s cooperation. They want the right to “call” the lease, but not that their tenants can “put” the lease to them.

In the real, commercial world – that’s fine. But, how should the rules work. What should be the “trade?”

There are two places in a lease where a landlord and its tenant may have provided for “recapture.” The one we raised last week was where the tenant has “gone dark,” closed its operation at the leased space. The other, probably more troubling (but that is for another blog posting) is where a tenant is seeking approval for an assignee or subtenant, and the landlord wants the opportunity to “recapture” all or part of the leased space.

This is probably a good time to introduce the elephant in the room. Landlords aren’t making that “phone call” or exercising their “recapture” right unless they have a replacement tenant in hand. That could be someone they have found on their own or it could be the very same assignee or subtenant with whom its existing tenant has inked a deal.

This elephant is what makes the entire recapture concept a little like three card monte where the house always wins because the deck is stacked. The landlord can only win. Until it has a replacement tenant that “it likes,” its original tenant is still on the hook. Being on the hook is fine. After all, that was the deal. But, the other side (the landlord getting the right to jump to a better tenant) wasn’t the deal; it was a negotiated deviation from the basic bargain. So, what does a landlord “pay” for that deviation or benefit?

If a lease didn’t have a recapture provision, and the landlord wanted to get unused space back (or even active space back), it could try to negotiate a new deal with its tenant, like “here is $X for you to turn the space back.” Then, the tenant could say “yes, no, or how about $Y”? The same economic negotiation should (and often does) take place when a lease is negotiated. That’s what is really going on when the negotiation turns to the “landlord’s” recapture clauses. When the concept winds up in a lease, the most common “bargain” is that the tenant will get paid enough to avoid a write-off of its physical investment in the space. Sometimes, typically with a supermarket or similar operation, a tenant will get back its yet undepreciated fixture costs. But, is that the only possible “trade” and why is that the most common outcome?

Money is money. What difference does it make how a landlord’s payment is to be calculated? Let’s take the case of a now-dormant supermarket. You can bet your bottom dollar that the existing supermarket tenant has been in touch with every other potential supermarket operator in the area, chains and independent operators. After all, only those users will have any interest in “paying” for the supermarket’s real property improvements, refrigeration equipment, cold cases, and other items, the use of which will save money for the replacement tenant. You can also bet that there are none out there. As long as we are betting, put your money on the side of the tenant having negotiated for the landlord to pay for all of those items (at least their remaining book value) if the landlord wants to get the “dark” space back. That’s why Ruminations thinks the parties have wasted their negotiating time and money.

The improvements and equipment are worthless to both parties. Why would the landlord pay more than a nominal sum (call it tribute) to its closed supermarket operator? Just pick up the phone and offer to let the supermarket tenant off the hook. Even if the tenant found its own (non-supermarket) replacement, it’s going to take it on the chin when it comes to the old improvements and equipment. Unless it is into masochism, when the landlord calls and offers to just take the space back, we suggest the supermarket say: “yes, thank you.”

So, where does “payment” for recapture really make sense? Here’s where, and we’ve never seen a deal where this really happens. There are leases that give a landlord the right to recapture space upon a proposed assignment or subletting. There are also leases that give a landlord 50% (usually) of assignment or subletting profit (whatever that might really be). Why don’t leases say that if a landlord exercises its right to recapture on these transfers, the tenant will get 50% of the “profit” for the balance of what would have been the term?

While we’re at it, why should a tenant be forced to accept a partial recapture when it finds a subtenant for less than all of the space? Where is the “trade”? Of course, a tenant can always make such a deal at the time of subletting, but why should it be forced to do so by the lease’s terms itself?

While we are bucking all of our industry’s conventions from this perch outside of the box itself, where are the leases that say the landlord will pay a commission-like amount to the departing tenant, say 5% of the new rent?

Well, here is our bottom line for today. And, it isn’t a neat bow and ribbon for this package. In fact, if you are disappointed that we’ve just hurled some firecrackers out there and haven’t cleaned up afterwards. That’s just too bad. Here at Ruminations, our goal is to get the mental juices rolling. To that end, please share your thoughts about what a recapture bargain could or should look like. There is a place to click for comments right under the title for today’s rant. Try it; you’ll like it. And, so will your Ruminating colleagues.

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Comments

  1. Ira: This is one of your more balanced articles as your viewpoints typically only favor the tenant’s point of view. That said, the premise of your article fails to recognize that the reason a landlord would typically want / need to recapture a space is because of tenant’s unilateral decision to cease operations. Such decision is outside the control of the landlord. After all, the landlord bargained for an operating merchant (especially in the example you offered about the supermarket which would undoubtedly be the anchor which drives traffic for the balance of landlord’s shopping center). Sure, many would say, then landlord should have demanded a continuous operating covenant in the lease. However, practically such is rarely given except for small shops and even if it is in the lease, few courts, if any are likely to enforce it. Except for perhaps a ground lease where the base building improvements would legitimately be depreciated over an extended time period, in my experience we would never offer to pay back the tenant anything for their failure to continue to operate. Why should the tenant be rewarded for wreaking havoc on landlord’s shopping center where likely many small shops have co-tenancy provisions specifically naming that supermarket?

  2. Joel R. Hall says:

    Ira, how did you get that elephant into the room? And are your kids responsible for cleaning up after him? Or, if not, then is that your editorial comment. on the issue? Anthony Cafaro Jr: Re paying the tenant for its unamortized improvements – it doesn’t matter whether the improvements will be useful or of no value to the next tenant. Money is money, like Ira (and his pachyderm buddy) says. The tenant wants to avoid a write off on its books. Termination is the Landlord’s decision. Regarding profits on assignment, knowledgeable landlords realize that they must share in the increased rental value (bonus value) of the lease, If the landlord wanted it all, the tenant would have no incentive to ask his transferee for anything more than the sticker price of the remaining unamortized portion of his investment. A tenant should have an offer-to-surrender provision in the assignment clause whereby he asks the landlord if it wants the space back. If landlord takes it back, landlord pays for the unamortized portion of tenant’s improvement expenditures. If landlord declines to take it back, then the tenant will go out and market the space. When he brings an assignee, the landlord must consider its consent under a reasonableness standard – there is no more recapture right (no second bite) . If landlord consents, then the parties might share 50%-50% in the bonus value after Tenant has first recouped its unamortized improvement costs and other costs of the transaction. And that’s no elephant manure!

  3. Mordecai Bobrowsky says:

    It’s also important to keep in mind why the tenant has decided to go dark. Is it because it just can’t make a go of it at this center? If so, perhaps there can be some sympathy for the tenant who may not be getting what it thought it was getting when the landlord wooed it over. However, if the tenant is leaving because it wants to jump across the street to the newer center, and is being offered a sweetheart deal to jump ship, then there is little room to argue that the tenant should be getting anything, as it is merely holding the landlord, and the shopping centre, hostage. A good recapture clause should get to the bottom of this decision and differentiate based on motivation.

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